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The Industrial Policy Effects of China’s Free Trade Zones: Prosper or Beggar Thy Neighbour

Sanya, China. – Photo credit: Denny Ryanto (Unsplash)

By Jane Du | 01 December 2023

The nationwide success of economic zones in China has given rise to significant implications for protectionist policies, indicating a shift in policymakers’ strategies towards incorporating regional industrial policies into broader economy-wide competition policies. Unlike the trend towards political centralisation, during much of the reform period, China’s local governments enjoyed substantial autonomy in shaping economic policies, contributing to the development of many thriving regional economies.


The Chinese Communist Party’s tradition of using growth-based criteria (e.g. local GDP growth) to evaluate and promote officials has led to a phenomenon akin to a “promotion competition” among Party members in the reforming era. Their enthusiastic pursuit of boosting regional growth effectively acted as a form of industrial policy, particularly evident in the case of economic zones. China’s success in fostering growth through economic zones has underscored the significance of granting higher economic autonomy to these zones, which in turn empowered local governors and enhanced their competitiveness within the Party’s “promotion competition”. This symbiotic relationship further solidifies economic zones as autonomous entities capable of generating substantial quasi-industrial-policy effects, particularly in industries aimed at boosting GDP.


This institutional autonomy of economic zones has continued to expand, most notably within the latest iteration of these zones, known as the Free Trade Zone (hereafter FTZ). Some of today’s FTZs are geographically located within earlier-established economic zones, such as Shenzhen and Hainan. In essence, for some FTZs, they are categorised as a type of economic zone within an economic zone, wielding the highest level of economic decision-making power among all types of zones in today’s China. When superimposed on land and population size, the quasi-industrial-policy effect becomes especially pronounced in FTZs.


A key political selling point for zones is their role in promoting regional development by attracting specific industries to particular locations. Indeed, there have been anomalous factor returns identified within existing economic zones, which were once thought to be a natural consequence of zones’ growth momentum. However, when geographic variations in capital returns appear within the same industry, the notion of general growth becomes less convincing. Some empirical evidences suggest that this phenomenon arises due to the preferential policies granted to zones, which attract firms away from neighbouring areas, thereby exacerbating economic disparities both within and outside the zone. Consequently, the observed geographic variations in capital returns can be largely attributed to the differential subsidies and/or rent-seeking activities of local governments.


Thus, a distinctive characteristic of FTZs lies in their de facto industrial policy impact. This policy-induced agglomeration primarily draws in industries that contribute significantly to GDP and exhibit spatial stickiness. As a result, it may distort the distribution of rents in and outside the zone, ultimately enhancing the ability of FTZs to capture these rents. The consequence of local government’s quasiindustrial policy is an uneven allocation of resources and a distortion in regional markets.


Today’s FTZs have a propensity to attract firms from high-growth industries; however, this does not necessarily imply a direct causal impact on individual firm growth. Similar to the case of Guangdong, there is a noteworthy overrepresentation of real estate-related industries within FTZs. This concentration of non-productive industries may lead to a permanent alteration in the regional factor distribution, thereby affecting productivity disparities both within and outside the zones. Consequently, unlike previous experiences, it becomes apparent that the most crucial lesson from today’s FTZs and their impact on regional growth is that the intricate relationship between industry clustering inside the zones and productivity changes in the surrounding areas is not always a “win-win” game.


From a broader perspective, economic principle suggests that factors of production become indifferent to agglomerating when institutional constraints are removed. In the context of spatial growth, the regional distribution of factor ratio can be permanently altered by industry clustering, leading to ongoing disparities in factor returns and productivity between zones and their surrounding areas. However, it is crucial to note that firms within FTZs are not necessarily more advanced in terms of productivity. If the policy-induced clustering of firms fails to enhance returns to inputs, it essentially amounts to a mere reallocation of productivity – a “siphon effect”.


In theory, firms that can benefit from the institutional framework of FTZs tend to prefer locating within these zones, where capital investments offer better returns, thus fostering faster growth in the zone area.  However, in reality, the continuous reduction of transaction costs (i.e. tax and tariff reduction), deregulation, and financial incentives (i.e. quota and subsidies) have resulted in uneven industry concentration within FTZs. The agglomeration resulting from favourable quasi-industrial policies may lead to the reallocation of productivity to FTZs or potentially result in the hollowing out of existing industries, ultimately having an adverse impact on regional growth – a “beggar-thy-neighbour” effect. In the long term, whether this effect is one of prosperity or detriment hinges on the interplay between the static loss stemming from resource reallocation and the dynamic gains associated with economies of scale during FTZ development.

This commentary is based on a recently published article by the author.

Jane Du is a Research Associate at the SOAS China Institute. Her publications on China’s economy have ranged from Mao’s collectivisation to Deng’s reforms, and the role of agriculture in China’s return to the market. Her further research focus is the historical development of China’s agricultural economy and its relationship to modern industrialisation.

The views expressed on this blog are those of the author(s) and are not necessarily those of the SOAS China Institute.